Go to the Globe and Mail homepage

Jump to main navigationJump to main content

Investing Strategy

Three signs of a coming stock market correction Add to ...

Signs are appearing, at least to those who like to study financial market runes, that equities could be in for a short-term fall.

Nothing is certain, of course, what with past performance being no guarantee of future returns as the standard disclaimer reads, but three different historical trends are suggesting equities could soon turn.

More Related to this Story

It all has to do with eight days in March, an aversion to cash and, contradictorily, falling equity market volatility.

First, the eight days.

Cat:e528746c-3414-401a-b14b-50247e3bdf01Forum:d0fa4e14-88d2-41f9-8a19-896bdff9544b

Morgan Stanley's European equity strategy team has taken note of the fact that this is the number of times last month that MSCI's main Europe index found itself up at least 50 per cent year-on-year.

"This is a rare event," it said in a note. "(It) has happened on only 80 individual days since 1919."

Crunching numbers, the Morgan Stanley team found that while such occurrences are a long-term bullish signal, they are bad news over the short haul.

Some 77 per cent of the time, equity markets have fallen 4 per cent over the next six months.

"The trigger for a correction is clear," strategist Teun Draaisma said. "I expect a continuation of good economic news to turn into bad market news.

The gist is that continued growth prompts central banks into a policy reaction or sends bond yields and inflation expectations up.

Cashing In

The second signal comes from Bank of America Merrill Lynch via the roughly 200 fund managers the bank polls every month to get ideas about asset allocation and market moves.

April's survey, released this week, found that cash holdings had dropped to 3.5 per cent of assets among the group.

Looking back, the bank said that on four out of the past five occasions that cash holdings have fallen that low, equities have declined by 7 per cent over the following 4-5 weeks.

"We have an amber warning light flashing," Patrik Schoewitz, BofA Merrill's European equity strategist, said of the finding.

Investors' low-yielding cash reserves, which were built up to huge levels at the height of the financial crisis, have been draining away for well over a year, mainly to the benefit of riskier assets such as equities.

At some point - perhaps now, if BofA Merrill is right - cash levels will normalize, cutting off riskier assets from some of their fuel.

The third sign of a correction is less numeric and more psychological.

State Street Global Advisors, an investor with $1.9-trillion in assets under management, says it is seeing growing interest from institutional investor clients in low-volatility equity strategies, essentially protection against stock market falls.

The best time to enter such strategies, State Street says, is when volatility has bottomed out and equities themselves have risen sharply from a low, as now.

The CBI Volatility Index is below last year's low and 71 per cent below last year's high. The MSCI all-country world stock index, meanwhile, has risen some 83 per cent from what many believe was its cycle low a little over a year ago.

Cyclical Bull

None of this is to say that such a correction will spread into the longer term.

BofA Merrill's Mr. Schoewitz said its study of corrections following cash reserves hitting 3.5 per cent "is a very short-term signal".

Furthermore, Morgan Stanley notes that while days of hitting 50 per cent-plus gains has led to a correction in the short term, on 96 per cent of occasions it has been followed by 10 per cent rise in equities over a 12-month period.

The firm believes that equity markets are currently in a cyclical bull market that should continue into next year But for the short term, the signs are there.

Follow us on Twitter: @GlobeInvestor

In the know

Most popular videos »

Highlights

More from The Globe and Mail

Most popular